In this note, I discuss the impact of the London Interbank Offered Rate (LIBOR) transition on credit lines, bank lending, and economic activity. I highlight the potential unintended impact of transitioning from credit sensitive reference rates to risk-free reference rates. The focus is on LIBOR transition in the U.S. where the near risk-free reference rate is the Secured Overnight Financing Rate (SOFR). It is well-known that credit market stress has macroeconomic consequences, (see Bernanke (2022) and the references therein). This note shows that LIBOR-SOFR transition might worsen these macroeconomic consequences.
First, drawing on a recent paper by Cooperman, Duffie, Luck, Wang, and Yang (2023), I discuss why the average borrowing cost on SOFR-linked credit lines could be higher than the average borrowing cost on credit lines linked to credit sensitive reference rates. The first section then highlights the fact that SOFR-linked credit line drawdown quantities could be significantly higher than LIBOR-linked drawdowns during periods of stress.
Second, I link the credit-line focused results of Cooperman et al. to the macroeconomic model implied results of Greenwald, Krainer, and Paul (2021) and show that during periods of stress or following macroeconomic shocks, while aggregate bank lending could grow, aggregate firm investment could drop. This dynamic could be intensified under large corporate SOFR-linked credit lines due to higher drawdowns. I highlight that underlying the boost in aggregate credit growth is a term loan crunch with adverse impact on small to medium-sized enterprises (SMEs). The LIBOR-SOFR transition could exacerbate the credit expansion – investment contraction dynamic and the adverse impact on SMEs during crisis episodes or following macroeconomic shocks.
In the last section, credit sensitive benchmarks are briefly discussed. This section shows that credit benchmarks that are poor proxies for average bank marginal funding spreads might increase frictions in credit markets. I will also note that the well-established economic principles and arguments in favor of developing the sustainable riskless interest rate benchmark, SOFR, can be similarly used to show that the economic and financial system will benefit from adopting robust and representative credit benchmarks.
[This research note is available only in downloadable PDF]
SOFR Academy ([email protected]), UC Berkeley ([email protected]), and NYU ([email protected]). The views expressed in this note do not necessarily represent the views of any of the institutions I am affiliated with. I am grateful to Darrell Duffie for helpful discussions and his comments. I am also grateful for conversations with Christopher Babu and Marcus Burnett.